CIMA - C2 Fundamentals of Financial Accounting
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90 6: From trial balance to financial statements ⏐ Part B Accounting systems and accounts preparation
A trial balance is done prior to producing the financial statements. It provides reassurance that the double entry
bookkeeping has been done correctly, but it does not reveal all possible errors.
2 The income statement
An income statement ledger account is opened up to gather all items relating to income and expenses. When rearranged,
the items make up the income statement for the financial statements.
2.1 The ledger account
The first step in preparing the financial statements is to open up another ledger account in the nominal ledger called the
income statement. In it a business summarises its results for the period by gathering together all the ledger account
balances relating to income and expenses. This account is still part of the double entry system, so the basic rule of
double entry still applies: every debit must have an equal and opposite credit entry.
This income statement is not the financial statement we are aiming for, even though it has the same name. The
difference between the two is not very great, because they contain the same information. However, the financial
statement lays it out differently and may be much less detailed.
The first step is to look through the ledger accounts and identify which ones relate to income and expenses. In the case
of Ron Knuckle, the income and expense accounts consist of purchases, rent, sales, bank loan interest, and other
expenses.
The balances on these accounts are then transferred to the new income statement account. For example:
$ $
Debit Income statement account 5,000
Credit Purchases account 5,000
PURCHASES
$ $
Trade payables
5,000
I/S a/c
5,000
RENT
$ $
Cash
3,500
I/S a/c
3,500
SALES
$
$
I/S a/c
12,500
Cash
10,000
Receivables
2,500
12,500
12,500
BANK LOAN INTEREST
$ $
Cash
100
I/S a/c
100
FA
S
T F
O
RWAR
D
Assessment
focus point
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Part B Accounting systems and accounts preparation ⏐ 6: From trial balance to financial statements 91
OTHER EXPENSES
$ $
Cash
1,900
I/S a/c
1,900
INCOME STATEMENT ACCOUNT
$ $
Purchases 5,000 Sales 12,500
Rent 3,500
Bank loan interest 100
Other expenses 1,900
(Note that the income statement account is not yet balanced-off.)
2.2 The financial statement
The items we have gathered together in the income statement are the same items needed to draw up the income
statement in the form of a financial statement. With a little rearrangement they could be presented as follows.
RON KNUCKLE
INCOME STATEMENT
$
$
Sales
12,500
Cost of sales (= purchases in this case)
(5,000
)
Gross profit
7,500
Expenses
Rent
3,500
Bank loan interest
100
Other expenses
1,900
(5,500
)
Net profit
2,000
3 The statement of financial position
The balances on all remaining ledger accounts (including the income statement account) can be listed and rearranged to
form the statement of financial position.
Look back at the ledger accounts of Ron Knuckle to see which ones are left. We still have cash, capital, bank loan, trade
payables, shop fittings, receivables and the drawings account.
Are these the only ledger accounts left? No: there is still the last one we opened up, the income statement account. The
balance on this account represents the profit earned by the business. It has a credit balance – a profit – of $2,000. (This
is the figure shown in the income statement financial statement.)
These remaining accounts must also be balanced-off, but since they represent assets and liabilities of the business (not
income and expenses) their balances are carried down in the books of the business. This means that they become
opening balances for the next accounting period.
FA
S
T F
O
RWAR
D
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92 6: From trial balance to financial statements ⏐ Part B Accounting systems and accounts preparation
3.1 Balancing off accounts
The usual method of balancing-off a ledger account at the end of an accounting period is illustrated by the bank loan
account in Ron Knuckle
's books.
BANK LOAN ACCOUNT
$ $
Balance carried down (c/d)
1,000
Cash
1,000
Balance brought down (b/d)
1,000
A credit balance brought down denotes a liability. An asset is represented by a debit balance brought down.
3.2 The capital account
A proprietor's capital comprises any cash introduced by him, plus any profits less any drawings. These three elements
are contained in different ledger accounts: cash introduced of $7,000 appears in the capital account, drawings of $1,500
in the drawings account and the profit is the $2,000 credit balance on the income statement account. It is convenient to
gather together all these amounts into one capital account, in the same way as we earlier gathered together income and
expense accounts into one income statement account.
DRAWINGS
$ $
Cash
1,500
Capital a/c
1,500
INCOME STATEMENT ACCOUNT
$
$
Purchases
5,000
Sales
12,500
Rent
3,500
Bank loan interest
100
Other expenses
1,900
Capital a/c
2,000
_____
12,500
12,500
CAPITAL
$
$
Drawings
1,500
Cash
7,000
Balance c/d
7,500
I/S a/c
2,000
9,000
9,000
Balance b/d
7,500
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Part B Accounting systems and accounts preparation ⏐ 6: From trial balance to financial statements 93
3.3 The statement of financial position
A re-arrangement of the outstanding balances completes Ron Knuckle's statement of financial position.
RON KNUCKLE
STATEMENT OF FINANCIAL POSITION AT END OF FIRST TRADING PERIOD
$
Non-current assets
Shop fittings
2,000
Current assets
Cash
6,500
Total assets
8,500
Proprietor's capital
7,500
Liabilities
Bank loan
1,000
8,500
When a statement of financial position is drawn up for an accounting period which is not the first one, then it ought to
show the capital at the start of the accounting period and the capital at the end of the accounting period. This will be
illustrated in the next example.
3.4 Summary
At the end of an accounting period, in preparation for producing the statement of financial position and income
statement:
(a) Ledger accounts are balanced
(b) A trial balance is prepared to check that the total of debit balances equals the total of credit balances
(c) A new ledger account called income statement account is opened
(d) Using double entry, accounts relating to income and expenses are transferred to the new income statement
ledger account
(e) Accounts relating to statement of financial position items are left as balances in the nominal ledger
Finally, the profit or loss on the income statement account, and the balance on the drawings account are transferred to
the capital account.
The trial balance is a useful starting point for the preparation of financial statements. Be prepared for an extract from a
trial balance, from which you then need to calculate a figure for inclusion in the income statement or statement of
financial position.
4 Balancing accounts and preparing financial statements
The exercise which follows is the most important so far. It uses all the accounting steps from entering up ledger
accounts to preparing the financial statements. It is very important that you try the question by yourself: if you do not,
you will be missing out a vital part of this text.
Assessment
focus point
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94 6: From trial balance to financial statements ⏐ Part B Accounting systems and accounts preparation
Question
Financial statements
A business is established with capital of $2,000, and this amount is paid into a business bank account by the proprietor.
During the first year's trading, the following transactions (in summary) occurred:
$
Purchases of goods for resale, on credit 4,300
Payments to trade payables 3,600
Sales, all on credit 5,800
Payments from receivables 3,200
Non-current assets purchased for cash 1,500
Other expenses, all paid in cash 900
The bank has provided an overdraft facility of up to $3,000.
Prepare the ledger accounts, an income statement for the year and a statement of financial position as at the end of the
year.
Answer
Open the ledger accounts so that the transactions can be posted. The next step is to work out the double entry
bookkeeping for each transaction. Normally you would write them straight into the accounts, but to make this example
easier to follow, they are first listed below.
(a) Establishing business ($2,000) DR Cash CR Capital
(b) Purchases ($4,300) DR Purchases CR Payables
(c) Payments to creditors ($3,600) DR Payables CR Cash
(d) Sales ($5,800) DR Receivables CR Sales
(e) Payments by debtors ($3,200) DR Cash CR Receivables
(f) Fixed assets ($1,500) DR Non-current assets CR Cash
(g) Other (cash) expenses ($900) DR Other expenses CR Cash
CASH
$ $
Capital 2,000 Payables 3,600
Non-current assets 1,500
Receivables 3,200 Other expenses 900
CAPITAL
$ $
Cash 2,000
TRADE PAYABLES
$ $
Cash 3,600 Purchases 4,300
PURCHASES
$ $
Payables 4,300
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Part B Accounting systems and accounts preparation ⏐ 6: From trial balance to financial statements 95
NON-CURRENT ASSETS
$ $
Cash 1,500
SALES
$ $
Receivables 5,800
RECEIVABLES
$ $
Sales 5,800 Cash 3,200
OTHER EXPENSES
$ $
Cash 900
The next thing to do is to balance all these accounts. It is at this stage that you could draw up a trial balance to make
sure the double entries are accurate. There is not very much point in this simple example, but if you did draw up a trial
balance, it would look like this.
Dr
Cr
$
$
Cash
800
Capital
2,000
Payables
700
Purchases
4,300
Non-current assets
1,500
Sales
5,800
Receivables
2,600
Other expenses
900
9,300
9,300
After balancing the accounts, the income statement account is opened and all the balances relating to income and
expenses are transferred. The balance on the income statement account is finally transferred to the capital account.
CASH
$
$
Capital
2,000
Trade payables
3,600
Receivables
3,200
Non-current assets
1,500
Balance c/d
800
Other expenses
900
6,000
6,000
Balance b/d (overdraft)
800
CAPITAL
$
$
Balance c/d
2,600
Cash
2,000
I/S a/c
600
2,600
2,600
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96 6: From trial balance to financial statements ⏐ Part B Accounting systems and accounts preparation
TRADE PAYABLES
$
$
Cash
3,600
Purchases
4,300
Balance c/d
700
4,300
4,300
Balance b/d 700
PURCHASES ACCOUNT
$
$
Trade payables
4,300
I/S a/c
4,300
NON-CURRENT ASSETS
$
$
Cash
1,500
Balance c/d
1,500
Balance b/d
1,500
SALES
$
$
I/S a/c
5,800
Receivables
5,800
RECEIVABLES
$
$
Sales
5,800
Cash
3,200
Balance c/d
2,600
5,800
5,800
Balance b/d
2,600
OTHER EXPENSES
$ $
Cash
900
I/S a/c
900
I/S ACCOUNT
$
$
Purchases
4,300
Sales
5,800
Gross profit c/d
1,500
5,800
5,800
Other expenses
900
Gross profit b/d
1,500
Net profit (transferred to capital
account)
600
____
1,500
1,500
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Part B Accounting systems and accounts preparation ⏐ 6: From trial balance to financial statements 97
So the financial statements will be as follows.
INCOME STATEMENT
FOR THE ACCOUNTING PERIOD
$
Sales
5,800
Cost of sales (purchases)
(4,300
)
Gross profit
1,500
Expenses
900
Net profit
600
STATEMENT OF FINANCIAL POSITION AS AT THE END OF THE PERIOD
$
$
Non-current assets
1,500
Receivables
2,600
4,100
Capital
At start of period
2,000
Net profit for period
600
At end of period
2,600
Current liabilities
Bank overdraft
800
Trade payables
700
1,500
4,100
Chapter roundup
• A trial balance is a list of nominal ledger account balances. It is prepared to check that the total of debit balances is the
same as the total of credit balances and offer reassurance that the double entry recording from day books has been done
correctly.
• An income statement ledger account is opened up to gather all items relating to income and expenses. When rearranged,
the items make up the income statement for the financial statements.
• The balances on all remaining ledger accounts (including the income statement account) can be listed and rearranged to
form the statement of financial position.
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98 6: From trial balance to financial statements ⏐ Part B Accounting systems and accounts preparation
Quick quiz
1 Fill in the blanks.
A trial balance is a list of ____________________________________________________________
_________________________________________________________________.
2 Five circumstances in which a trial balance might balance although some of the balances are wrong are:
(1) _______________________
(2) _______________________
(3) _______________________
(4) _______________________
(5) _______________________
3 Which of the following errors would result in a trial balance failing to agree?
A Failing to record an invoice from a supplier in the accounting system
B Recording a non-current asset purchase as an item of revenue expenditure
C Recording an expense payment as:
Dr bank a/c Cr expense a/c
D Recording an expense payment as:
Dr expense a/c Dr bank a/c
4 When preparing a trial balance, the clerk omits the balance of $2,000 on the receivables account. This error means that
the total of debit balances will exceed the total of credit balances by $2,000. True or false?
5 A business has the following extract from its trial balance
$
Trade receivables 5,000
Bank overdraft 2,000
Trade payables 7,000
Inventory 4,500
What is the figure for current assets?
A $9,500
B $7,000
C $11,500
D $9,000
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Part B Accounting systems and accounts preparation ⏐ 6: From trial balance to financial statements 99
Answers to quick quiz
1 A trial balance is a list of nominal ledger account balances.
2 (1) Omission of a transaction completely
(2) Posting to the wrong ledger account
(3) Compensating errors
(4) Errors of principle
(5) Errors of original entry
3 D This is an example of a failure of the basic rules of double entry, so the trial balance will not agree.
A This is an error of omission, the financial records will be incomplete but the integrity of the double entry process
is not impaired.
B This is an error of principle, confusion between capital and revenue expenditure has occurred.
C This is a reversal error, the trial balance will agree because debits = credits, however the accounts are incorrect.
4 False. The omitted balance is an asset account and thus a debit. So in the trial balance the total of credit balances will
exceed the total of debit balances by $2,000.
5 A Current assets are inventory ($4,500) and trade receivables ($5,000)
Now try the questions below from the Question Bank
Question numbers Page
20–22 396
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